Pension is one of the most efficient financial assets. It is a fund to which the employers keep adding funds during the employment years of the employees, and the employees can make periodic withdrawals to support their retirement. In essence, employees get a part of their wages deducted and saved as pension as the financial cushion to ensure a good quality of life post-retirement.
Individuals in the UK have access to state pensions, occupational pensions, and personal pensions. The state pension is given by the State or the government and currently stands at a maximum of £134.25 per week. Additionally, occupational pensions are set up by specific employers for the benefit of their employees. In contrast, personal pensions are individual arrangements made by people with providers like insurance companies.
A wide variety of UK pension schemes are available for individuals to choose from. Some of them are provided by the employers, while individuals invest in others in their own capacity. They also differ in terms of obligations, benefits, eligibility, and associated costs.
What is SIPP, and How Does it Work?
SIPP is a self-invested personal pension plan available to the residents of the UK. It is a tax-efficient savings mechanism for retirement that allows the taxpayers to defer a part of their pre-tax income and invest it in different asset types available.
The most significant contribution of SIPP is towards tax advantage. Individuals can claim a tax benefit on the contributions made towards SIPP. For instance, a UK taxpayer with a basic rate of 20% can contribute £10,000 towards his pension account and reclaim £2,000 as a tax benefit that gets deposited into his SIPP account. However, the tax relief has a threshold of contributions up to £40,000 only.
SIPP also offers the benefit of diversification and flexibility to the individuals. They can invest in a basket of asset types, including shares, bonds, and ETFs, and in different geographies and currencies to bring about long-term growth at low cost and optimum level of risk. The diversified options of assets include short-term government bonds, developed market government bonds, investment-grade corporate bonds, inflation-linked bonds, high yields, and emerging markets government bonds, developed market equities, emerging market equities, real estate, and commodities.
Rules of SIPP
Employees usually make use of SIPP as a top-up to their workplace pension schemes. It allows them to contribute higher towards their retirement voluntarily, make their own investment decisions, save taxes, and maximize the tax relief.
The rules for contributions towards SIPP follow the same guidelines as standard pension schemes. The maximum that an individual can save in a SIPP is either 100% of the total annual salary or the yearly allowance of £40,000. However, for income in excess of £150,000 per year, the amount of allowance gets reduced by £1 for every £2 of excess income and can reach a minimum of £10,000.
Furthermore, if an individual has not made full use of his annual pension allowance in the past three tax years, he can carry forward the provisions. However, SIPP is subject to a maximum permitted accumulated value of pension fund, called Lifetime Allowance, of £1 million.
Withdrawal of Funds from SIPP
The funds in SIPP become available to individuals only when they reach the age of 55. After reaching this pre-defined age, individuals can take the money out either all in one go or in a series of lump sums whenever needed.
Individuals must be cautious that only the withdrawal of the first 25% of these uncrystallized fund pension lump sums is tax-free, while the remaining is subject to income tax deducted at the source. Therefore, the depositors may also choose to avail Flexi-access drawdown that allows withdrawal of 25% of the funds tax-free while the remaining amount remains invested. The income from these investments can be withdrawn as and when needed.
The third option for the withdrawal of funds from SIPP is a phased drawdown that combines the benefits of uncrystallized fund pension lump sums and Flexi-access drawdown. This alternative is most suitable for individuals who wish to take the money from their pension fund without triggering the £10,000 Money Purchase Annual Allowance contribution limit.
Pros and Cons of SIPP
SIPP holds the potential to offer several advantages over the traditional pension schemes. Most importantly, SIPP allows individuals to take control of their investments in their hands. They can choose from a variety of financial instruments to invest in, facilitating significant growth and diversification of risks.
Additionally, the taxpayers are also eligible for a minimum of 20% and a maximum of 45% tax relief on their contributions towards SIPP. The withdrawal of funds from SIPP comes with an array of options to choose from, depending on the needs and personal circumstances. Individuals also get to transfer all their pensions into one place through SIPP, manage their investments online, and on their own, taking charge of their investment decisions.
However, SIPP comes with a set of risks and disadvantages. The money is locked down for many years, and the tax savings are capped with a threshold limit. Moreover, withdrawals of funds are also subject to income tax. If the investments in and withdrawals from SIPP are not managed efficiently, individuals may end up paying a high amount of fees and taxes.
Is SIPP the Right Choice for you?
SIPP, similar to the other forms of savings and investments, has its pros and cons, rewards, and risks. On the one hand, it does put the individuals in the driver’s seat of their investment decisions and gives them the flexibility to control their goals, risks, and rewards. However, on the other hand, lack of knowledge and professional experience in handling financial investments may also lead to higher risks and poor decisions.
Therefore, although SIPP offers flexibility, tax benefits, independence, and diversification, the final decision of choosing it as the retirement savings option depends on the age, financial knowledge, and unique circumstances of the individuals. It is an excellent choice for retirement; however, the specific benefits and risks must be weighed in before making the investment decision.